It’s been a tough year for Chinese technology stocks. The fast-growing sector has led emerging market (EM) indexes down amid rising U.S.-China tensions. The upside: The decoupling of Chinese tech from U.S. peers is set to accelerate amid a struggle for tech dominance, giving it diversification benefits. And valuations have fallen.
Chinese tech stocks typically trade at a premium to developed market stocks or peers given their greater growth potential. But that premium (the blue line above) has come down sharply this year, while market attention to the U.S.-China relations risk, as measured by our BlackRock Geopolitical Risk Indicator (BGRI), has increased (the orange line). Our outlook for global technology stocks broadly is positive, and we believe the door may be open for global investors to diversify their exposure and step into a long-term opportunity in Chinese tech.
Reasons for optimism
Tech stocks are the largest constituent in both the U.S. and Chinese equity markets. Downward earnings revisions, stemming partly from regulatory changes affecting matters such as content dissemination and licensing, have weighed on sentiment for Chinese tech stocks in 2018. Analysts project a rebound in 2019 amid strong consumer demand, fiscal stimulus and waning regulatory hurdles. In addition, the U.S. and China tech sectors are increasingly different, creating distinct opportunities for investors.
The U.S. tech sector has a global bent versus China’s domestic one. Concentration is greater in China, where just three stocks represent most of the tech market cap. Other distinctions: The Chinese market for tech services is larger, the Chinese consumer base has a different income profile and the regulatory framework in China is developing faster. We see changes in trade and the competition for tech dominance amplifying these differences and limiting co-development. Reduced IPOs and cross-border investment could be byproducts of ongoing tensions, yet we see China’s focus on domestic demand and self-reliance as positives amid trade disputes. Cross-country investment restrictions could limit redundancy and direct competition, while rivalry-fueled innovation may benefit both tech sectors. A near-term uncertainty posing an upside or downside risk: a potential meeting between U.S.-China leaders later this month. Yet we see Chinese and U.S. tech decoupling even without worsening tensions, as China devotes capital to its innovation priorities.
The long-term potential in Chinese tech firms may be underappreciated amid strained U.S.-China relations. We advocate digging deeper than the index-dominating mega-cap names in China to uncover opportunities in smaller software and services firms. In the U.S., we favor software as a service (SaaS) firms, as companies large and small move their systems to the cloud. Valuation multiples in the U.S. tech sector have risen in the post-crisis period but are now in line with their five-year historical average, and they do not look particularly extended over a longer horizon. We maintain our favorable view of global tech stocks and advocate broadening exposure to capture the diverse opportunities in China and the U.S.